inflation and output
TRANSCRIPT
Inflation and Output
Jenny Xu, Department of Economics, SFU
chapter 15
PART 4The Economy in the Short Run
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-2 Copyright © 2005 McGraw-Hill Ryerson Limited
Volcker’s Disinflation
In the late 1970s, inflation increased rapidly By 1979 US inflation = 11.3%; Canada = 9.2%
Paul Volcker was appointed the Chairman of the US Federal Reserve in Sept. 1979 sharply increased interest rates GDP & employment fell sharply in the U.S.
U.S. slowdown decreased demand for Canadian exports
Bank of Canada followed US lead in raising interest rates• Interest rates doubled – 1978 = 8.6%; 1981 = 17.8%
Sharpest recession since the 1930s followed• Unemployment rate in 1980 = 7.5%; in 1983 = 11.9%
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-3 Copyright © 2005 McGraw-Hill Ryerson Limited
Why? Extending the Basic Keynesian and AD-AS Models
This chapter extends the basic Keynesian and AD-AS models to allow for price inflation and the reactions of Central Banks
We use the aggregate demand-inflation adjustment diagram to analyze the recessions of the early 1980s & 1990s
I. Inflation, Spending and Output: The Aggregate Demand/Inflation
(ADI) Curve
How does the predictable response of central banks affect aggregate demand?
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-5 Copyright © 2005 McGraw-Hill Ryerson Limited
FIGURE 5.1
The Aggregate Demand/Inflation (ADI) Curve: Relationship between short-run equilibrium output Y and the Rate of inflation rate π
When Inflation increases, Aggregate Demand declines: Why?
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-6 Copyright © 2005 McGraw-Hill Ryerson Limited
Why the ADI curve are downward-sloping?
Because of Bank of Canada’s response to inflation rate π
Bank of Canada’s choice of the real interest rate depends on the rate of inflation Bank’s stated goal:
- to maintain core inflation between 1 and 3% When π is high, BOC will try to reduce the aggregate
spending by setting a high interest rate.
Π increases r increases autonomous expenditure decreases Y decreases ADI curve downward sloping
Bank of Canada’s Policy Reaction Function - the predictable action which a policymaker takes in response to the state of the economy
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-7 Copyright © 2005 McGraw-Hill Ryerson Limited
FIGURE 15.2
An Example of a Bank of Canada Policy Reaction Function
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-8 Copyright © 2005 McGraw-Hill Ryerson Limited
Aggregate Demand and Inflation (π)
After 1973 – surge in inflation.
Central bank reaction function Increase in inflation (p) causes the bank to set a
higher real interest rate. Result: reduces both aggregate demand and short-
run equilibrium output.
Aggregate demand (and equilibrium output) is lower when inflation is higher.
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-9 Copyright © 2005 McGraw-Hill Ryerson Limited
Numerical Example of an Aggregate Demand (ADI) Curve
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-10 Copyright © 2005 McGraw-Hill Ryerson Limited
Shifts in Aggregate Demand (ADI)
ADI curve = The relationship between inflation & Aggregate
Demand
holding all other factors other than inflation constant
When these other factors change, the ADI curve shifts –examples: Changes in autonomous aggregate demand
E.g. increase in demand for Canadian exports OR more government spending
Bank of Canada’s reaction function may also shift Example: 1988 - new lower target band for inflation set
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-11 Copyright © 2005 McGraw-Hill Ryerson Limited
Changes in Autonomous Aggregate Spending
Autonomous planned aggregate expenditure The portion of PAE that is determined outside the
model E.g. increase in autonomous PAE – shifts ADI right
If households desire to consume more at the same income level, this shifts ADI rightwards
If firms make more private sector investments at the same interest rate, this shifts ADI rightwards
If governments increase spending, this shifts ADI rightwards
If foreigners suddenly want to buy more Canadian goods and services, this shifts ADI rightwards
A decrease in autonomous PAE shifts ADI leftwards
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-12 Copyright © 2005 McGraw-Hill Ryerson Limited
FIGURE 15.3
Effect of an Increase in Exogenous Spending
ADI
ADI’
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-13 Copyright © 2005 McGraw-Hill Ryerson Limited
Increase in Exogenous Spending - 1
C Autonomous consumption
Suppose Consumers become more optimistic and spend more – ADI shifts rightwards
Surveys track “consumer confidence” Major concern for current forecasts [1990 Gulf War saw a major decline in US
consumer confidence – shifted ADI left]• A major change from previous wars
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-14 Copyright © 2005 McGraw-Hill Ryerson Limited
Increase in Exogenous Spending - 2
T Net taxes
Cut in taxes stimulates consumer spending Example: Martin tax cuts of 2001 stimulated
Canadian economy in 2002 • Helped Canada avoid US recession
Increase in transfer payments has same type of impact - stimulates consumer spending Issue – income distributional impact
• Since high income people typically save a greater % of their income, 1$ in tax cuts or transfers received by the affluent generally produces less stimulus to aggregate demand than 1$ benefit received by low income groups
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-15 Copyright © 2005 McGraw-Hill Ryerson Limited
Increase in Exogenous Spending - 3
I Autonomous private-sector investment
Development of a new cost-saving technology will increase investment spending by firms
Example: the late 1990s saw a major investment boom in USA in telecommunications, computer industries “Dot.Com Boom” in investment has been
followed by “Dot.Com Bust” since 2000
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-16 Copyright © 2005 McGraw-Hill Ryerson Limited
Increase in Exogenous Spending - 4
G Government purchases
Increased spending directly increases Aggregate Demand Roads, hospitals, schools may also affect
potential output, but only in the longer term Buying more domestically produced
military hardware also has immediate stimulative impact
• Wartime Demand for military goods was a major factor in increased Aggregate Demand during WWII, Korea, Viet Nam wars
- But in 1990 Gulf War, “hi-tech”, short war meant stimulus to demand was smaller than the impact of decline in consumer confidence
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-17 Copyright © 2005 McGraw-Hill Ryerson Limited
Increase in Exogenous Spending - 5
NX Net Exports
Increased demand for Canadian products by foreigners
Example: During 1990s, US economy grew strongly –
implying strong demand for Canadian exports, more than offsetting the decline in Canadian government spending after 1995
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-18 Copyright © 2005 McGraw-Hill Ryerson Limited
Changes in the Bank of Canada’s Policy Reaction Function and the ADI Curve (a)
Bank of Canada’s reaction function the real interest rate the Bank of Canada sets at
each level of inflationThe Bank of Canada may change its policy reaction
function (e.g. in 1988) Tightening monetary policy
For a given inflation rate, the Bank of Canada sets a higher real interest rate than before
Same effect as a reduction of Autonomous private-sector investment
Easing monetary policy For a given inflation rate, the Bank of Canada sets a
lower real interest rate than before Same effect as a expansion of Autonomous private-
sector investment
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-19 Copyright © 2005 McGraw-Hill Ryerson Limited
A Tightening of Monetary PolicyFIGURE 15.4
ADI'
ADINew policyreactionfunction
Old policyreactionfunction
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-20 Copyright © 2005 McGraw-Hill Ryerson Limited
Shifts in ADI vs. Movements Along ADI
Movements along ADI Downward slope of ADI shows the inverse
relationship between inflation and aggregate demand Changes in the inflation rate cause Bank of Canada to
change the real interest rate Changes in real interest rate cause changes in ADI and
short run equilibrium output & employment (with a lag)
Shifts in ADI Caused by factors that change ADI at a given level of
inflation Autonomous changes in spending Changes in the Bank of Canada’s policy reaction
function
II. Inflation and Aggregate Supply
In the short run, how do firms decide how much to produce?In the long run, is the amount the economy can produce
influenced by the inflation rate?
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-22 Copyright © 2005 McGraw-Hill Ryerson Limited
Expectations of Inflation influence behavior - & behavior determines reality
At any point in time, buyers and sellers have an expectation of inflation when negotiating contracts - & they will build it into the contract The higher the expectation of inflation, the higher is
the nominal price negotiated E.G., when firms expect higher wages and increases in
the costs of other inputs, their selling price will increase If wages and other costs are expected to increase,
firms will want to raise pricesLong-term wage and price contracts build in
increases in wages and prices that depend on inflation expectations A low rate of expected inflation therefore tends to lead
to a low rate of actual inflation A high rate of expected inflation therefore tends to
lead to a high rate of actual inflation
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-23 Copyright © 2005 McGraw-Hill Ryerson Limited
Inflation Inertia
Inflation inertia Low inflation tends to change relatively slowly.
Expectations about future inflation are strongly influenced by current inflation.
This leads to long-term wage and price contracts that preserve low inflation.
When expected inflation = actual, nobody has a reason to change behavior
EQUILIBRIUM !!! BUT - other factors can upset the situation.
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-24 Copyright © 2005 McGraw-Hill Ryerson Limited
A Virtuous Circle of Low Inflation and Low Expected InflationFIGURE 15.5
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-25 Copyright © 2005 McGraw-Hill Ryerson Limited
Key factor that causes changes in inflation –output gap
Key factor that causes changes in inflation –output gap (Y-Y*) No Output Gap
– Inflation will not change; Recessionary Gap
– Inflation decreases; Expansionary Gap
– Inflation increases;
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-26 Copyright © 2005 McGraw-Hill Ryerson Limited
ADI Diagram
Long-run aggregate supply (LRAS) A vertical line showing the economy’s potential
output Y* In long run, Y = Y*
Short-run aggregate supply/Inflation Adjustment (IA) A horizontal line showing the amount supplied at the
current rate of inflation, as determined by past expectations and pricing decisions
Represents the fact that, in short run, firms produce what the market can absorb, at preset prices
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-27 Copyright © 2005 McGraw-Hill Ryerson Limited
The Aggregate Demand–Inflation Adjustment (ADI–IA) DiagramFIGURE 15.6
Long-run aggregate
supply LRAS
Aπ
Y Y*
Inflation adjustment IA
Aggregate demand ADI
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-28 Copyright © 2005 McGraw-Hill Ryerson Limited
Short-Run Equilibrium
In the short run, the inflation rate is determined by past expectations and pricing decisions
Since, in the short run, firms produce what the market can absorb at preset prices, total output equals the level of demand that is consistent with that inflation rate short-run equilibrium output is demand determined Graphically, short-run equilibrium occurs at the
intersection of the AD curve and the IA curve
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-29 Copyright © 2005 McGraw-Hill Ryerson Limited
Output Gap and Inflation
Output gap The difference between potential output Y* and
actual output Y Y* - Y
In the short run Y may equal Y* Y may differ from Y*
Y > Y* expansionary gap Y < Y* recessionary gap
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-30 Copyright © 2005 McGraw-Hill Ryerson Limited
Suppose: No Output Gap
Y = Y* Actual output equals potential output
Firms are satisfied Sales equal normal production rates
• No unwanted accumulation of inventories• No unwanted depletion of inventories
Firms have no incentive to change their prices relative to other prices• So if other prices are expected to rise at x%, firm will want
to increase own prices by the same %
Inflation rate tends to remain the same
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-31 Copyright © 2005 McGraw-Hill Ryerson Limited
Inflation and Recovery from a Recessionary Gap
If economy has a recessionary gap (Y<Y*) Elimination of gap occurs – given the reaction
function of the central bank!
Firms not selling as much as expected will slow the rate at which they increase their prices This will cause the inflation rate to fall Short Run Aggregate Supply/Inflation Adjustment
curve (IA) shifts down As inflation falls, the Bank of Canada lowers the real
interest rate Output rises and unemployment falls (with a lag)
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-32 Copyright © 2005 McGraw-Hill Ryerson Limited
The Adjustment of Inflation When a Recessionary Gap ExistsFIGURE 15.7
LRAS
IA
IA'
ADI
A
B
π
π*
Y Y*
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-33 Copyright © 2005 McGraw-Hill Ryerson Limited
Expansionary Gap
Expansionary output gap Y > Y*
Actual output is greater than potential output Firms are over-utilizing resources
Sales exceed normal production rates• Inventories are depleted – firms have to react
Firms have incentive to increase prices more than the increase in their costs
If all firms do this then ….. Inflation rate tends to increase
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-34 Copyright © 2005 McGraw-Hill Ryerson Limited
Inflation and Elimination of an Expansionary Gap
If Y > Y* - expansionary gap Elimination of gap implied by the central bank
reaction function
Firms experiencing high demand will Increase prices more than costs This will cause the inflation rate to rise
Short Run IA shifts up As inflation rises, the Bank of Canada raises the real
interest rate Output falls and unemployment rises (with lag) Y falls towards Y*
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-35 Copyright © 2005 McGraw-Hill Ryerson Limited
The Adjustment of Inflation When an Expansionary Gap ExistsFIGURE 15.8
LRAS
π
π*
YY*
IA
AD
A
IA'B
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-36 Copyright © 2005 McGraw-Hill Ryerson Limited
A Self-Correcting Economic Model (with the help of the Central Bank!)
A self-correcting policy mechanism Given enough time, output gaps tend to disappear
with the help of the central bank
This result contrasts with the simple version of the Keynesian model which - focuses on the short run when prices do not adjust
and ignores the long-run adjustment period - does not incorporate the Bank of Canada’s policy
reaction function
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-37 Copyright © 2005 McGraw-Hill Ryerson Limited
Long Run Equilibrium
LR equilibrium Actual output equals potential output and the
inflation rate is stable Y = Y* Graphically, it is where the AD curve, the IA line, and
the LRAS line all intersect at a single point Central Bank is satisfied with inflation, so no changes
to interest rates
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-38 Copyright © 2005 McGraw-Hill Ryerson Limited
Timing
If self-correction (with the bank’s fixed reaction function) is too slow, then more aggressive stabilization may be needed Change of reaction function is possible Fiscal policy may also be useful
If correction is rapid Then the case for active stabilization is weaker
The BIG problems for policymaking in the real world are uncertainties in diagnosis & lags in policy impacts
Large gaps take longer to fix & have large costs Greater justification for policy intervention
III. Sources of Change in Inflation
What kinds of economic shocks might change the rate of inflation?
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-40 Copyright © 2005 McGraw-Hill Ryerson Limited
Why might inflation change ?(a)
Excessive Aggregate Demand (AD) Too much spending chasing too few goods If the economy is already close to capacity, then a
surge in spending may cause an expansionary gap (Y > Y*) Example: US wartime spending during Viet Nam war in
1960s
It is known as “demand-pull inflation ”.
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-41 Copyright © 2005 McGraw-Hill Ryerson Limited
War and Military Buildup as a Source of InflationFIGURE 15.9
π
Y*
LRAS
IA
ADI'ADI
B
A
π'
IAπ
Y* Y
ADI'
LRAS
B
A
IA'C
a) An increase in military spending shift ADI curve right to ADI’. So at the new short-run equilibrium point B, there is a expansionary gap.
b) This gap leads to a rising in inflation. So IA curve will move up to IA’, which leads to an increase in real interest rate because of the BOC’s policy response function. Then the economy will move to point C. At this point, the output Is back to the potential output (Y*), but the inflation is higher than before( from π to π’)
Y
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-42 Copyright © 2005 McGraw-Hill Ryerson Limited
Can central bank prevent the increase in inflation in this case?
Yes!
If the central can tighten the monetary policy- setting a higher real interest rate at any given level of inflation
This can shift the ADI curve leftwards and thus offsets the increase in demand by the government
-- eliminating or at least moderating the inflationary impact of the military purchases.
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-43 Copyright © 2005 McGraw-Hill Ryerson Limited
Sources of Change in Inflation (b)
Inflation Shocks - Sudden change in the normal behavior of inflation, unrelated to output gap. Example: 1973 oil price shock. (In 1973, at the time
of the Yom Kippur War between Israel and a coalition of Arab nations, OPEC cut its supplies of crude oil to the industrialized nations, quadrupling world oil prices.) Output down, inflation up May take a long time to return to previous output and
inflation levels
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-44 Copyright © 2005 McGraw-Hill Ryerson Limited
The Effects of an Adverse Inflation ShockFIGURE 15.10
π
Y′ Y*
π'
LRAS
IA'
IA
ADI
ADI'
A
B C
Starting from Long-run
Equilibrium point A, an adverse inflation shock
move IA curve to IA’. The new
short-run equilibrium point
B will imply a recessionary
gap. If there is no active
monetary policy, the economy will return to point A eventually. But
the economy will suffer a long recession.
The Bank of Canada can ease
the monetary policy by setting
a lower real interest rate at
any inflation rate. So this will
shift the ADI curve right to
ADI’, which help the economy to
move back to the point C. At point C, the economy does not have
any recessionary gap, but the cost of this strategy
is that the inflation will remain at the
high level.
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-45 Copyright © 2005 McGraw-Hill Ryerson Limited
So inflationary shock really pose a dilemma for policy makers!
If the central banks leave their policies unchanged, a “steady-as-she-goes” approach –inflationary will eventually subside, but the nation may experience a lengthy and severe recession.
If the central banks act aggressively to expand the aggregate demand, the recession will end more quickly, but inflation will stabilize at a higher level.
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-46 Copyright © 2005 McGraw-Hill Ryerson Limited
Random Shocks to Output ?
Shocks to potential output (adverse aggregate supply shocks) can happen Example: Weather shocks & crop losses ?
“Real Business Cycles” literature argues that random shocks to potential output are the source of unavoidable short run fluctuations in the macro-economy
Long-term shocks can affect potential output trend but this is a different problem - permanently lower rate of output growth Examples:
• Costs of energy conservation after 1973• Increase in costs of security after 9/11
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-47 Copyright © 2005 McGraw-Hill Ryerson Limited
The Effects of a Shock to Potential OutputFIGURE 15.11
π
Y*' Y*
π'
LRAS
IA'
IA
ADI
A
B
LRAS'Starting from
Long-run Equilibrium point
A, an adverse potential output shock move LRAS
to LRAS’. So now A represents a
expansionary gap. So the inflation
will adjust and IA will move to IA’. According to the policy reaction
function, the real interest rate will increase, which
induce the economy to move to the new long-run equilibrium
point B. Note that the decline in
output is permanent.
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-48 Copyright © 2005 McGraw-Hill Ryerson Limited
IV. Controlling Inflation
What should policymakers do if inflation is too high? Bank reaction function implies a given speed of
reduction of inflation Inflation can be slowed faster by policies that reduce
aggregate demand more aggressively I.e. change in central bank’s reaction function
Costs more lost output & more unemployment
Benefits faster transition to lower trend inflation
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-49 Copyright © 2005 McGraw-Hill Ryerson Limited
(b) FIGURE 15.4
A Tightening of Monetary Policy
ADI
ADI'
New policyreactionfunction
Old policyreactionfunction
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-50 Copyright © 2005 McGraw-Hill Ryerson Limited
The Short-Run and Long-Run Effects of a Monetary TighteningFIGURE 15.12
Y Y*
12% IA
C4% IA′
Y Y*
LRAS
B12%
ADI'
LRAS
BIA
ADI
ADI'
A
V. Limitations of the Aggregate Demand-Aggregate Supply Model
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-52 Copyright © 2005 McGraw-Hill Ryerson Limited
Limitations of the Aggregate Demand-Aggregate Supply Model (b)
Like the basic Keynesian model, ADI model is framed in terms of level of potential output Can rephrase in growth terms – potential output (Y*)
grows over time Recessionary gap can open even when actual output
is growing, if growth is less than normal
So far, have assumed that net exports are autonomous BUT Decreases in the real interest rate will cause a
depreciation of the Canadian dollar Net exports will increase (with a lag)
Foreign trade effects accentuate impacts of monetary policy
Principles of Macroeconomics, 2nd Canadian Edition Slide 15-53 Copyright © 2005 McGraw-Hill Ryerson Limited
Macro Economics in an Open Economy
So far – we have been discussing a closed economy C + I + G = GDP
But Exports are almost 40% of Canada’s GDP – so a more accurate assumption is: C + I + G + (X – M) = GDP Chapter 16 considers trade